Working with ESCOs: Friends or Foes?

Some new guys in town could either be your friends or enemies. They are called energy services companies (ESCOs).

ESCOs have been around since the 1980s, but utility deregulation may accelerate their role in your traditional service work. ESCOs took root after the Public Utility Regulatory Policy Act (1978) required electrical utilities to finance facility retrofits meant to slow our growing dependence on foreign oil producers.

Deregulation of electric power generation by the Energy Policy Act of 1992 and retail competition throughout half the states have spurred utilities to set up holding companies and organize unregulated ESCO subsidiaries to compensate for revenue lost to competitors. ESCOs can complete the site work in three ways: build their own in-house organization, buy contractors, or outsource the work to established contractors. This article focuses on partnering with ESCOs, since that seems to be the way most contractors can benefit from this new business.

When ESCOs come to town, they sell owners on energy efficiency retrofits through energy audits and long-term payback analysis, and provide the financing that makes energy savings attractive to financial officers through "performance contracts." Commercial/industrial owners who wish to navigate the uncertainty of buying deregulated energy often prefer one-stop shopping at a firm that can take over all their complex responsibilities. Contractors may not be aware of the ongoing negotiations until they lose a favored customer to an ESCO. For a typical example of what they offer, refer to the home page shown in the illustration from Constellation Energy Source at www.cesource.com.

If you know how to work with ESCOs, you can enjoy the benefits of deregulation through projects that might not be done without their marketing. This article addresses both sides of the ESCO market and some anticipated future trends.

How big is it?

According to a report by Frost & Sullivan (www.frost.com) titled, "North American Non-Residential Energy Management Services Markets," the total EMS market generated revenue of $23.3 billion in the United States and Canada in 1998. This includes all beyond-the-meter energy services, including performance contracting, energy audits, equipment sales for energy management purposes, and project management. Industry participants generating this revenue include several types of competitors with differing labels, such as ESCOs, energy service providers (ESPs), contractors, consultants, and facility management companies. Deregulation of the electric utility industry, continued advances in technology, and increasing marketing communications are anticipated to push EMS revenues higher, toward a predicted $43 billion by 2005.

There are about 125 ESCOs listed at www.espio.com. This site includes a standard template that displays details on each company's sales volume, location of field offices, and types of work being offered. A sample company can be viewed free of charge, but full access to all companies listed requires a subscription.

The National Association of Energy Services Companies represents ESCOs. Additional information is provided at www.naesco.org, including links to suppliers and library references for sale. NAESCO also conducts a certification program and provides links to firms that meet the requirements for certification.

Don't let the relatively small number of ESCOs fool you. It is a national marketer that can easily take away your local facility services customers by signing up the headquarters office in its home state. For example, PGE Services in California signed up Lockheed Martin, headquartered in Bethesda, Md., to service all its facilities in 26 states through a partnership with GroupMac, the national contracting roll-up firm.

According to a NAESCO representative, "an ESCO is a business that develops, installs, and finances projects designed to improve the energy efficiency and maintenance costs for facilities over a 7- to 10-year time period. These measures often include high-efficiency lighting, high-efficiency heating and air conditioning, efficient motors and variable speed drives, and centralized energy management control systems. ESCOs generally act as project developers for a wide range of tasks and assume the technical and performance risk associated with the project. Typically, they offer the following services:

- develop, design, and finance energy efficiency projects;

- install and maintain the energy efficient equipment involved;

- measure, monitor, and verify the project's energy savings; and

- assume the risk that the project will save the amount of energy guaranteed."

Financing is the key

Most utility ESCOs can finance the projects from their immense capital. But when it runs short, they can turn to independent sources. The Energy Services Group of GE Capital (www.gecapitalenergy.com) is a major financial backer of ESCOs, with nearly $1 billion invested,. The GE site includes a comprehensive glossary of leasing terms.

According to a GE official, "Leasing presents a flexible and creative method of acquiring equipment, ancillary supplies, extended warranties, and training. In order to maximize the benefits of leasing, you need to have a good understanding of the basics."

Here are several examples of performance contracts GE Capital has funded.

- A Midwestern school district is in the process of a lighting retrofit in 15 different school buildings, replacing 40-year-old equipment. The project totaled $2 million and is financed over a 10-year period.

- A Midwestern steel mill was looking to finance a $6.5 million substation, with power distribution equipment, a coal preparation facility, and arc furnace transformer and vaults. GE provided construction term funding during the 15-month installation period, then converted to a 96-month permanent loan. The rate was indexed to 90-day GE Capital commercial paper, reset every 90 days.

- A university on the West Coast needed to finance over $8.7 million worth of chillers, boilers, lighting components, and air-handling units. GE Capital financed the entire project over an 11-year term.

To bundle or not to bundle

Customer interest in bundled energy and services may be what stimulated Custom Energy, LLC, one of the older ESCOs headquartered in Overland Park, Kan., to buy energy marketer Strategic Energy, Ltd., of Pittsburgh.

According to its announcement, "Customers will derive benefits in energy purchasing both on the supply and demand sides. Custom Energy helps reduce end users' electricity demand and usage. SEL provides value on the supply side by objectively shopping the nation's power grid and natural gas network for the most cost-effective reliable power and gas."

Custom Energy provides a comprehensive explanation of it services, including answers to frequently asked questions at www.customenergy.com. It operates 10 offices and covers most of the country.

Another combination was the purchase of CES/Way, billed as the largest independent ESCO, by Sempra Energy Services of southern California. Sempra Energy was formed from the merger of several utility companies, including San Diego Gas and Electric and Southern California Edison. Its Web site is at www.sempra-esco.com.

Among its claims are, "With a performance contract from Sempra, old and obsolete equipment is replaced with newer, more efficient technologies, such as equipment such as lighting, heating and cooling systems, and temperature controls. Facilities will experience fewer breakdowns and reduced maintenance costs. When occupants enjoy improved lighting, better air quality, and more comfortable temperatures, they are likely to be happier and more productive." Sempra's project of relighting the Statue of Liberty was accomplished at no cost to the public. Instead, the energy savings resulting from the more efficient equipment installed paid for it.

Contractors and ESCOs weigh in

We asked several managers on both sides for their opinions.

"Two things are driving the changing marketplace: relationships and money. I can't say which comes first," Mike Hastings, a senior engineer with Combined Energies (www.combinedenergies.com) of Augusta, Maine, said succinctly. Combined Energies is an ESCO established in 1996.

Our interviews with both electrical contractors and ESCOs bear out that statement. The preferred relationship for both appears to be outsourcing.

Lee Haislip, vice president of Haislip Corporation, an electrical contractor in Chantilly, Va., terms outsourcing as "mutually beneficial." The new market, he said, is providing enhanced relationship opportunities by working with such firms as Evantage, the unregulated ESCO of Dominion Resources (www.evantage.com). Evantage has logged projects from Texas to Maine, according to its news releases.

Haislip appears to have adjusted to working for ESCOs with good humor, an optimistic attitude, and a vision of new and evolving relationships that are more complementary than competitive. But, he said that when the deregulation movement began, some contractors had concerns. For example, an ESCO could learn some contracting secrets and then cut the company out. Haislip thinks that fear is unfounded, especially since ESCOs need the quality performance that only an established electrical contracting firm can provide.

ESCOs are not trying to take over the market; in fact, they create opportunities for contractors to access big clients, Haislip opined. ESCOs who try to do their own contracting would face a tremendous learning curve.

Michael Hastings' experience bears out Haislip's comments about contractor concern at the beginning of the deregulation movement. One contracting firm initially complained about Combined Energies' tactics, but that was settled after the contractor realized that ESCOs were adding to the market, not taking away from it. Now Hastings said contractors call Combined Energies and ask, "When is the next project?"

Hastings also said he believes there is a place for both large and small electrical contracting firms because ESCOs increase the available construction contracts to work on. "The contracts that we develop normally would not be done. So rather than taking work away from contractors, we are adding to it. We have already seen a great deal of growth among the contractors that we are working with."

In terms of pricing subcontracts, Hastings reported that Combined Energies has accepted the low bid on only about 50 percent of their projects.

Just one big happy family?

Hastings' and Haislip's remarks were nicely complemented by those of Ray Ehmer, vice president of Reliant Energy Solutions (www.reliantenergy.com), a utility ESCO based in Houston, Texas. Ehmer's goal is to "nurture" clients in Texas. If the business environment is favorable, though, Reliant can also leverage relationships elsewhere. He agreed that some contractors were threatened by ESCOs early on in the deregulated energy market and saw them as competitors. Soon, however, it became apparent that ESCOs provided opportunities to work with and partner with contractors. Ehmer emphasized that the right approach to his firm must accompany normal contracting attributes: joint marketing opportunities; efficiency in material procurement; leveraging finances; coordinating on the front end after engineering applications.

Ehmer said Reliant has no restricted list of partners. Rather, Reliant has formed relationships with contractors project by project. When contracting companies establish a good track record, their reputation serves both themselves and the ESCOs.

Reliant prefers outsourcing because it doesn't need to integrate vertically. Rather, they want to concentrate on the business development and sales side at the front end, including their technical and engineering capabilities. Ehmer, revealing his visionary tendency, said "conceptual engineering" is the focus. Reliant also wants to emphasize strong project management and financial capabilities. It uses several companies for financing, including GE Capital.

In some instances, clients want to retain their preferred contractors, as Lynn Talbot of Corporate Marketing, Sempra Energy Services Company (www.sempraenergy.com), acknowledged. Reliant can hire these preferred contractors into the project. Ehmer acknowledges that a "trust level" can be built up after one or two projects.

Further corroboration comes from Jorge Ortiz, director of Sempra construction services. He said the long-range outlook for relationships between contractors and ESCOs is really good because, "both ESCOs and electrical subcontractors can benefit from each other's knowledge and skills. Electrical subcontractors are needed on almost every project ESCOs develop."

Contractors wishing to partner with Sempra, "need to have experience, to be of significant size in terms of earnings, and to be able to produce good references." After an initial screening of contractors, Sempra's projects are issued for competitive bids, usually between two or three contractors. The lowest bidder typically gets the job, but not always.

Working with Sempra recently was Hensel Electric Company, of Waco, Texas, a 20-years veteran of contracting. While this was the first project his firm had done through an ESCO, Alan Hensel, secretary/treasurer, said it had been "mutually beneficial," since it added to their work rather than taking away from it. He observed that when an ESCO is able to outsource its contracting needs, it saves itself a lot of problems. For example, it's easier to partner than to hire and fire labor as needed. He was cautiously optimistic about the future but observed that the NECA staff in his chapter had "talked a bit about potential problems."

Pepco-Services, Inc., (www.pepco-services.com) also favored outsourcing for the $60 million in performance contracting it did in 1999. It has bought only one contractor so far. ESCO operations include marketing and sales, engineering, and construction management.

The marketing plan includes building customers in the Mid-Atlantic area from Pennsylvania to Georgia. They don't have a particular profile of a contractor to partner with, but if a customer prefers his own contractor, they will use that firm, according to an executive spokesman. They usually subcontract to the lowest bidder, but they do have a preferred list of contractors they have worked with successfully. Still, one contractor working for Pepco-Services expressed reservations and concerns about restricted profits and possible future direct competition if they should acquire more contractors.

So is there a downside?

According to Bryan Macuci, senior vice president of MONA Energy Services (www.monaenergy.com), there is a downside to the previous, perhaps somewhat idealistic, descriptions of the relationships between electrical contracting firms and ESCOs. MONA Energy Services, of Clinton, Md., founded in 1997, is in a unique position to see both the contractors' and the ESCOs' points of view.

MONA Electrical Construction, Inc. was founded in 1966 as an electrical service company. Over the years, MONA has expanded into all aspects of electric, energy, and building technologies solutions needed by the client. Macuci believes that the primary danger to contractors will be gradual erosion of their market share. In many cases there won't be a dramatic grab to purchase electrical contracting firms. Rather, as ESCOs come to town, there will be incremental changes.

Foreign ESCOs will first subcontract with local firms to gain their knowledge. Gradually, as they develop experience, ESCOs may expand their ability to provide both labor and materials. He fears that eventually ESCOs will purchase units of labor only, rather than subcontracting whole projects. Thus, while contractors' businesses may at first improve with the new ESCOs, gradually their position could become weaker as the ESCOs gain more field experience.

Speaking for the contractors, Macuci said, "Be aware!" Contractors may sometimes have their heads in the sand because of doing business as usual, particularly with the booming economy. The real danger for contractors is that they don't know what they don't know.

In other words, contractors who have not spent the last few years researching and envisioning the deregulated energy market may lose out and lose out big. Macuci said this trend will particularly impact small firms lacking a strategic focus, management depth, diversity, and specialization in the converging electrical, energy, and building technology marketplace. He advised electrical contractors to both team and compete with ESCOs and to become more innovative in providing energy solutions for clients.

In summary, the two most important lessons are that electrical contractors need to educate themselves-fast-about the changing marketplace and that they need to retain their loyal customer base, especially since ESCOs have reported they will be persuaded to use a client's preferred contractor.

ESCOs represent both opportunities and challenges. Contractors must understand how ESCOs will impact the future basis of their market position in terms of geographic location, size, quality of service, and specialization. No one can predict the future, but how contractors approach ESCOs now will affect how it turns out.

Legal Traditions Impacted by Deregulation

New legal and contractual complications may impact the traditional contracting industry. Chris Brasco and Fred Mendicino, specialists in construction and surety law and partners in the law firm of Watt, Tieder, Hoffar and Fitzgerald, L.L.P., in McLean, Va., compiled the following utility unregulated ESCO issues:

- Electrical and mechanical contractors must learn to negotiate contracts with ESCOs instead of their traditional prime contractors. The new relationships may include long-term subcontracts for power equipment retrofits and other related services, such as VDV wiring and maintenance agreements, that take new forms. In addition, some trade contractors must be prepared to negotiate the outright acquisition of their company by utility ESCOs seeking to acquire instant trade expertise.

- Given their gigantic financial assets and multiple profit centers, utility holding companies can bid construction work through their wholly owned ESCOs below market rates to gain a competitive advantage and offer building owners services in addition to energy supply.

- ESCO strategies may have an anti-competitive effect on construction markets if they acquire an appreciable percentage of the construction market and acquire, or otherwise gain control over, a substantial portion of specialty contractors. As such, it is reasonable to assume a reduction in competition and overall rise in construction costs. If utility ESCOs gain a significant share of the market for construction services, they may tie the sale of power to other supplies or services that contractors normally provide-state codes of conduct notwithstanding.

- It is likely that new forms of insurance will evolve to cover the risks of ESCO operations. These new policymakers will have to assess the risks associated with the blending of the owner-builder-operator roles unique to ESCOs, as well as address the professional liability issues created by ESCOs with in-house design/build capabilities.

- Should an owner agree to purchase all or a portion of the materials for a construction project from an ESCO and employ trade contractors separately only to perform the labor, a surety company attempting to underwrite a bond for these trade contractors faces altered risk factors. The risk-to-return ratio associated with a "labor only" contract exceeds that posed by a traditional subcontract, where the risk and premium cost covers both labor and material.

- The possibility of wholesale power marketers "wheeling" power over long distances on the interstate infrastructure creates a risk of transmission grid and distribution line failures. The economic consequences of power loss could initiate litigation between the additional players in the unregulated power generation marketplace. New state and federal regulations may be needed to mitigate such litigation.

TAGLIAFERRE is Proprietor of C-E-C Group and Susan GREENWOOD is a lecturer in Sociology at the University of Maine. He can be reached at either (703) 321-9268 or lewtag@aol.com.